The majority of "option" adjustable rate mortgages are due to be recast in the coming months. This means clients who appear to be in good financial shape might suddenly find themselves under water as monthly mortgage payments balloon.

The recasting of some $253.25 billion in option adjustable-rate mortgages (ARMs) has been predicted to peak between 2010 and 2012, according to SNL Financial in Charlottesville, Va. (see Figure 1).

The attractive monthly teaser rates of option ARMs helped fuel the housing boom in 2005,  2006 and 2007. These rates allowed borrowers to repay even less than interest in the first months of their mortgages.

But the chief problem with these products is the unusually large amount of "negative amortization" such repayments can trigger. In other words, the borrower's loan balance could likely exceed the amount originally borrowed. Add declining home values to the equation and you have a recipe for defaults.

"The time to start ferreting out clients with option ARM problems is now," says Chris Zehnder, a CFP and ex-mortgage banker in Saint Cloud, Fla.

Zehnder says he regularly updates his clients' net worth reports when he holds periodic meetings with them. In doing so, he has observed major shifts in clients' net worth primarily due to shifts in the value of their real estate portfolios.

When he spots a problem in the clients' portfolios, he discusses available options with them. Among the choices they have is to make loan modifications, sell the property or arrange short sales. The key, he says, is to check a client's mortgage note for the specific terms. Just because a mortgage has an adjustable rate does not mean it's an option ARM. And in the current low-interest-rate environment, automatically converting a client from an ARM to a fixed-rate mortgage could do more harm than good for certain borrowers.

An "option" or "payment option" ARM gets its name from the various payment options generally offered borrowers. Most commonly the payment options include a traditional principal and interest payment over 15, 30 or 40 years; an interest-only option; and a minimum payment option, which is generally less-than-interest-only in the first year.

The payment option selected by most borrowers during the housing boom was the deceivingly low less-than-interest-only teaser rate, which usually lasts just three months. After that, the interest rate rises to market rates, adjusting periodically. Although interest rates on this type of ARM shoot up almost immediately, most borrowers continued in the years right before the housing bust to make monthly payments based on that low teaser rate, so that additional accrued interest went toward the mortgage balance.

Meanwhile, as interest rates rose, so did the monthly payment. But option ARM terms generally limit payment increases to 7.50% annually. That means any amount over that payment cap also gets added to the loan balance.

"I've seen [payments] based on start rates of 0.50%," says Standard & Poor's Brian Grow, who co-authored a study suggesting negatively amortized option ARMs are prone to default.

Adds Roelof Slump, managing director of Fitch Ratings in New York: "It has been our observation that a high percentage of [option ARM] borrowers were negatively amortizing right out of the gate."

The terms of option ARMs are complex and may vary. But the payment shock typically hits when the borrower reaches one of two triggers, says the Federal Reserve. One of the triggers comes when the principal owed hits a specified threshold in the note. Generally, that's a "negative amortization" ceiling equal to 110% to 125% of the original amount borrowed. In that case, the borrower's initially flexible payment options are reduced to just one: monthly payments of both principal and interest calculated based on the remaining term.

The other trigger point usually kicks in every five years-when the loan is automatically recalculated or "recast," based on principal and interest owed over the declining remaining term. The 7.50% annual payment cap is removed for this five-year recalculation, the Federal Reserve warns.

The danger is that the option ARM's loan balances and payments will escalate amid lower home values. The payments can rise significantly if the minimum payment rate moves up to the full interest rate, if there's a requirement that principal be added to the monthly payment and if the borrower is forced to pay back an escalating loan balance triggered by negative amortization, the S&P study indicates. 

Fitch reported in 2009 that when option ARM monthly payments are recast, the payment increases average 63%. Since then, thanks to record-low interest rates, that payment shock is believed to have ebbed-at least, for now.

Standard & Poor's research indicates that once the loan balance exceeds the home's value, the borrower is more likely to default. As for all the government loan modification programs aiming to curb defaults, "the only [remedy] that will really help the option ARMs is principal forgiveness," says Nancy Reeis, co-author of the Standard & Poor's study. But analysts agree that few lenders are forgiving principal on option ARMs.

So far, according to Standard & Poor's research, the majority of option ARM loans that reached their negative amortization limits are in default. That includes 55% originated in 2005 and 70% originated in 2006, Reeis says. However, about 50% of the outstanding option ARMs originated in 2005 have yet to be fully recast to include principal and interest. About 75% and 90% of those originated in 2006 and 2007, respectively, have yet to be recast.

Financial planner Zehnder suggests that advisors look over the terms of the mortgage note in their clients' closing packages. If that's lost, "I suggest they get with the title company or attorney or the real estate agent who closed on the deal," Zehnder says.
He often puts on his banker's hat to see whether the loan payment is affordable for his client. If the monthly mortgage payment is 50% of income, you may need to talk with someone about a short sale, or try to find something more affordable, he says.

For heavily leveraged borrowers, Zehnder has had success getting mortgages refinanced through the Farmington Hills, Mich.-based Mackinac Bank. Federal programs will refinance as much as 125% of the home's value, he adds.
For a short sale, Zehnder advises talking to a real estate professional. Consider a realtor who has a "CDPE" designation issued by the Distressed Property Institute in Austin, Texas. You'll need to determine the property's market value. Area sales records may be online with the property appraiser's office. Web sites such as www.zillow.com also provide information, though online sales data may quickly prove outdated. "The lender won't even talk to you until you have an offer," Zehnder warns.

"If you can do a 30-year, fixed-rate mortgage, do it!" says Keith Springer, president of Capital Financial Advisory Services in Sacramento, Calif. If your client can't get a fixed-rate mortgage and needs to refinance, you might consider a 5/1 ARM, which has a fixed interest rate for five years and then becomes a one-year adjustable rate mortgage afterward. These have been running around 3%, says Springer, a CFP who doubles as a mortgage broker. "Even the new adjustable-rate mortgages are going to be cheaper." Fixed-rate mortgages may also have 40-year terms, which can spell long-term lower payments. Of course, the longer the term, the longer interest accrues.

Rich Arzaga, a CFP and founder of Cornerstone Wealth Management Inc. in San Ramon, Calif., says that whenever his clients inquire about option ARMs, he'll immediately refer them to a reliable mortgage broker-somebody with whom he can negotiate. Or he'll send clients to a lawyer or real estate broker, depending on the situation.

U.S. Housing and Urban Development spokesman Brian Sullivan suggests that borrowers in trouble visit the Web site www.makinghomeaffordable.gov. By clicking on "eligibility," and checking out the site's interactive program, a borrower can determine whether he might be eligible for various forms of government relief. A borrower might also get free counseling by calling 888-995-HOPE (4673).

"Nobody should pay others who guarantee they can modify a mortgage," Sullivan stresses. "Always talk to the lender. Lots of people get themselves in trouble when they don't answer the phone or open mail."

Standard & Poor's analysts say option ARMs are not getting modified at the same rate as other loans because loan balances are so much higher than home values.

Nevertheless, there is some good news on the option ARM mortgage front. For one thing, option ARMs are largely concentrated in California, Florida, Nevada and Arizona, according to Fitch.

Also, both Fitch's and Standard & Poor's analysts agree, the U.S. government's long-lasting low interest rate policy appears to be cushioning the blow of these products on borrowers.

Also, Slump notes, at least in California, home prices have risen 8% over last year. With rising home values, borrowers are better able to keep making mortgage payments and to qualify for refinancing.

But not all regions-even those in California-can boast rising home values, he says. Nor are rising home prices predicted to continue. "Across the United States as a whole, there is likely to be another 10% national price decline from this point forward," Slump says.